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A failure to bond over eurobonds

The idea of issuing common European bonds as a permanent solution to the eurozone’s debt crisis has attracted plenty of attention ahead of today’s meeting of the European Council (16 December).

The controversial suggestion was given fresh legs by Jean-Claude Juncker, the prime minister of Luxembourg, and Giulio Tremonti, the finance minister of Italy, ten days ago. They claimed, in an article in the Financial Times on 5 December, that arrangements could already be well advanced by the time of today’s EU summit.

But the suggestion was shot down by Angela Merkel, Germany’s chancellor, who flatly refused to entertain the idea, even though many economists hold the view that eurobonds could go a long way towards solving the current crisis.

The proposal from Juncker and Tremonti is as much political as fiscal. They said that their plan would demonstrate politicians’ commitment to the single currency.

Under the plan, ‘E-bonds’ would be jointly issued by a new European Debt Agency (EDA) with a common low rate of interest. Juncker and Tremonti portrayed an EDA as a permanent replacement for the European Financial Stability Facility (EFSF), set up in May following the Greek crisis.

They proposed that the common bond market would eventually reach liquidity levels equivalent to that of US Treasuries. A liquid market as large as that, they claimed, would deter speculation against individual member states. As a result, government borrowing costs would be reduced.

Crucial to the success of the eurobond idea is how European and national debt would be considered distinct from each other. They would exist side by side, with the EDA financing up to half of a country’s debt in the form of eurobonds. The rest would continue to be considered national debt in order to retain the notion of moral hazard.

Countries might end up paying a higher rate of borrowing on their remaining national debt.

The idea that there is a difference in status between the proposed common bonds and national borrowing is vital if any such scheme is to work. Common bonds would have a senior status compared with national debt so they would always be the first to be serviced, and the least likely to default.

Pooling debt

In May, Bruegel, a Brussels-based think-tank, issued a paper written by Jacques Delpla and Jakob von Weizsäcker, which outlined a plan for common eurobonds similar to the one raised by Juncker and Tremonti.

Their “Blue Bond” proposal suggested that countries should pool national debt equivalent of up to 60% of gross domestic product (GDP) as senior sovereign debt. That, said the report’s authors, would reduce the cost of borrowing for that part of the debt.

Their idea is that any national debt beyond these ‘blue bonds’ would be issued as national and junior debt – what they called “red bonds” – with procedures for an orderly default. The Bruegel paper argued that such bonds would help enhance financial discipline. Since all but four countries in the eurozone currently have national debt greater than 60% of GDP, many would still issue national bonds.

Merkel does not want to be seen to be bailing out more profligate countries, which is how signing up to an E-bond scheme is likely to be seen

The thinking behind this is that the two types of debt would look substantially different. In the case of a partial default, the junior section would be affected first, while common debt would be hit only by the part of the default that had not already been absorbed. This means the blue bonds would become less risky than is the case at present, while the junior debt would become riskier, leading to a bigger difference in interest rates. The paper argues that this would produce higher and lower yields at the same time.

This is seen as attractive because lower yields cut the cost of financing government debt. On the other hand, higher yields indicate that a country may be behaving fiscally recklessly. In this sense, the common E-bond scheme is seen as an improvement on the existing situation when Greek bond yields did not rise enough to send an early warning that all was not well.

The Bruegel paper suggests that there should be different blue-bond allocation for each country in order to encourage fiscal discipline. Countries with strong fiscal policies would be allowed to borrow up to the full 60% of GDP, while others that were seen as weaker would be allowed a lower proportion.

This differentiates the Bruegel idea from the Juncker-Tremonti proposal, which suggests that, while up to 50% should be issued as a common bond, member states could, “in exceptional circumstances”, finance up to 100% this way.

Germany’s fear is that by taking on a common bond, including the weaker economies of Ireland and Greece, its own credit worthiness would suffer and its cost of borrowing would rise. The popular attitude in Germany is that the issuance of a common bond is nothing more than a permanent system of subsidies from the fiscally strong to countries with less fiscal discipline.

The German finance ministry is worried that its own borrowing costs, which are currently the lowest in the EU, would increase.

Borrowing costs

Erik Jones, a professor at the Johns Hopkins Bologna Centre, published a paper on eurobonds in March. He argued that common bonds would help prevent market speculation and that, contrary to German fears, the country’s borrowing costs would come down.

“The common eurobonds would trade in a much deeper market than German debt does presently and they would be at the heart of day-to-day banking operations across the eurozone,” he said. “Hence they should be cheaper to finance and not more expensive.”

It is an opinion that does not wash in Germany. With regional elections in Baden-Württemberg on 27 March, Merkel does not want to be seen to be bailing out more profligate countries, which is how signing up to an E-bond scheme is likely to be seen.

Michael Leister, a fixed-income analyst at the German bank WestLB, said the idea of a common E-bond would be “impossible” to sell to the German people. “The trouble with the idea is that there does not appear to be any incentive for countries to put their houses in order. In terms of getting spending under control, it offers no incentives,” he said.

Politically, it is difficult to see how Merkel could soften her stance on E-bonds now. Popular opinion in Germany has made that impossible. However, if the alternative is continued emergency financial aid to troubled member states or defaults that harm Germany’s banking structure, the prospect of common bonds might begin to look rather more attractive. It is an idea that is unlikely to go away.